Investing in a Delaware Statutory Trust has become appealing to many investors, especially for estate planning. After entering the trust through a 1031 Exchange, investors may enjoy tax-deferral benefits as well as the potential for passive income. You’re only required to pay capital gains taxes upon the sale of the DST. However, what happens to a 1031 DST when the owner passes away? Who inherits the fractional interests, and what are the tax implications? Realized 1031 has shared a guide to answer these questions.
Understanding the 1031 Exchange Step-Up in Basis
One potential tax benefit associated with holding aDST is the step-up in basis. Under current federal tax law, when a person passes away, the tax basis of their appreciated assets may be adjusted to reflect the fair market value at the time of death. This adjustment—known as a step-up in basis—can reduce or eliminate the capital gains tax liability that would otherwise apply if the asset were sold.
Let’s say that Mary invested in a DST for $500,000, and the value appreciated by $200,000 by the time of her passing. She also had $100,000 in capital gains taxes after exchanging for several years, always deferring her tax liability. The value of her fractional interest upon her passing is $700,000. Thanks to the step-up in basis, this value will become the new cost basis. If her heirs later sell the DST interest for that same amount, there would be no capital gains tax due on the sale.
Estate Planning Considerations
DSTs are sometimes incorporated into estate planning because they:
- Offer passive ownership (no management responsibilities)
- May provide heirs with fractional real estate interests
- Can allow for a step-up in basis under current tax law
Because DST interests are illiquid and governed by both tax and securities laws, estate planning involving these structures should be conducted with professional guidance.Transfer of DST Ownership to the Heirs
DST interests are classified as personal property, not real estate itself (but they may be eligible for tax deferral benefits thanks to Revenue Ruling 2004-86). For this reason, they become part of the investor’s estate and are transferable to heirs based on the instructions outlined in a will, trust, or through state intestacy laws if no estate plan exists.
Heirs who inherit DST interests do not assume management control over the trust or its underlying real estate. All operational responsibilities remain with the DST sponsor. However, the heirs may have certain choices depending on the terms of the DST agreement and the investor’s estate plan. These may include:
- Selling the interest if there is a secondary market.
- Holding the interest until the DST liquidates the underlying property.
- Transferring the interests into their own estate plans or investments.
Tax Implications for Heirs of a DST Interest
When a Delaware Statutory Trust (DST) interest is inherited, the cost basis is typically adjusted to the fair market value of the interest at the time of the original investor’s death, under current federal tax law. This is commonly referred to as a step-up in basis, and it may reduce or eliminate capital gains taxes on appreciation that occurred during the original owner’s lifetime.
Heirs may be subject to capital gains tax if the DST interest appreciates after the date of inheritance and is later sold for a gain. Additionally:
- Distributions from the DST (if any) are generally taxable as ordinary income.
- If the estate is large enough, federal or state estate taxes may apply.
- Tax treatment may vary depending on how the DST liquidates its underlying assets and the timing of distributions to beneficiaries.
Because DSTs are typically long-term, passive investments, the value of the underlying real estate may fluctuate based on market conditions. Beneficiaries are encouraged to:
- Confirm and document the stepped-up basis at the time of inheritance
- Monitor any future appreciation or income distributions
- Consult a tax professional to ensure proper reporting and compliance with estate and income tax rules
Wrapping Up: DST Step-Up in Basis Considerations
In the context of estate planning, one potential advantage of holding an interest in a DST is the step-up in basis. When a DST investor passes away, the tax basis of the inherited interest may be adjusted to its fair market value at the date of death. As the new owners of a fractional interest, these heirs can then enjoy the potential for passive income from the investment. For families focused on multi-generational wealth transfer, DSTs may support objectives such as asset continuity and tax deferral. However, investors and their beneficiaries should consult with qualified tax and estate planning professionals to understand the specific implications and ensure compliance with evolving tax laws.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.hellodata.ai/help-articles/how-do-dst-ownership-structures-work-in-real-estate
